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Lawsuits: Bruce Berkowitz's Secret Sauce?

By Jessica Alling - Apr 5, 2013 at 12:58PM

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Every investor has to carefully evaluate a company before shelling out cash, but does Berkowitz know something you don't when it comes to lawsuits?

Bruce Berkowitz is undoubtedly one of the most respected value investors in the game; when he makes a move, people pay attention. But it's hard to ignore one common factor shared by some of his top holding -- outstanding lawsuits. With all of the uncertainty surrounding the potential costs of these legal battles, it's no wonder share prices are depressed, but is Berkowitz investing because of, or in spite of the lawsuits? Let's take a look at the two biggest cases at hand and see how investors, like Berkowitz, should approach companies with legal battles in the future.

Bank of America (BAC 3.39%) is the No. 2 holding for Berkowitz's Fairholme Fund. Not only have Fairholme and Bruce had to weather the storm from BAC's Countrywide legacy issues, but also the more recent spat between the bank and another Fairholme holding, MBIA (MBI 6.29%). The insurer had a big win earlier this week when an appeals court ruling stated that the bank would be required to buy back securitized loans even if they were not in default. The ruling, which partially overturned a lower court ruling, noted that as long as MBIA could prove that the loan "materially and adversely" affected its interest, B of A would be required to repurchase the loan. The court panel also approved MBIA's rights to recover "rescissory damages," which was previously denied by the lower court ruling.

As expected, Bank of America intends to appeal the case since it would set a precedent for other insurers to sue for the same reason. The bank's most recent SEC filing stated that its current legal reserves for mortgage buyback losses would not be sufficient if the court ruled in favor of MBIA, leading investors to worry about its ability to cover legal losses in the future.

As if one wasn't enough
Another notable insurer is also seeking to recoup losses from mortgage-backed securities sold by Countrywide and Merrill Lynch (both part of the current B of A) -- AIG (AIG 2.80%). As the Fairholme Fund's top holding, AIG enters the fray with a big incentive to win in court -- $10 billion. But any progress in the case has been derailed as the parties try to determine if AIG has the right to sue in the first place. The securities were bought as part of the NY Fed's bailout of AIG, which B of A argues assumed the rights to sue when ownership changed hands. Though the Fed previously stated that it did acquire the rights, and AIG was out of luck, a recent statement from a Fed employee reversed that, saying that his previous comments were not meant to take anything away from AIG. Only time will tell how this suit plays out, but either way, one of Berkowitz's biggest holdings is going to lose.

How to evaluate a company's legal battles
A lawsuit generally isn't good for businesses, especially if investors see the potential costs and losses as reason to stay away. As many know, plenty of investors jumped ship when Bank of America's legal troubles ballooned, thanks to its Countrywide acquisition. But to a value investor, a mass exodus like that may present an opportunity. Based on Warren Buffett's mantra of being greedy when others are fearful, and fearful when others are greedy, the reduced stock price created by decreased confidence in the banks' ability to win cases is just the right time for a value investor to jump in. But only after making sure of one very important thing: that the lawsuits don't change the fundamentals of the business.

Now, it's no secret that B of A's earnings have not been up to par, largely because of continued legal fees and settlements. But the majority of the suits are legacy issues, without much influence on the current business model. Because of the mess from the financial crisis, Bank of America does not use the same type of practices that created the majority of its cases. Likewise for AIG, which has even decided to invest in whole mortgages, where it can evaluate the entire loan portfolio, instead of pools of mortgages that were sold to it by other institutions.

There's no way for me to say one way or the other if Berkowitz chooses to invest because of the lawsuits, or in spite of them. But one thing is clear -- as an investor, he is willing to diverge from the crowd and walk straight toward an investment that others would shy away from. And with his analyzing skills, he's determined that the businesses can withstand the bevvy of legal battles without losing their path toward future gains. As a Foolish investor, this might not be a bad approach to emulate. 

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Stocks Mentioned

Bank of America Corporation Stock Quote
Bank of America Corporation
$35.99 (3.39%) $1.18
American International Group, Inc. Stock Quote
American International Group, Inc.
$60.28 (2.80%) $1.64
MBIA Inc. Stock Quote
$12.51 (6.29%) $0.74

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